Alternative assets are set to become a larger part of investors’ portfolios, but investment managers face challenges capturing alpha and managing client expectations
by Daniel Dunkley
For most wealth managers, financial planners and pension fund managers, alternative investment classes such as private equity, private debt and infrastructure have historically been a tiny part of the overall investment picture. But investment professionals are now considering private capital allocations as barriers to entry ease and market dynamics demand a more diversified approach.
In 2022 the Chartered Alternative Investment Analyst Association (CAIA) published Portfolio for the future, a report on what it calls the five essential marks of effective capital allocation. The report declares the “rise of a new era”, in which private capital will sit more prominently alongside traditional asset classes such as stocks and shares in global investment portfolios.
At the end of 2020, it says, alternative investments totalled US$18tn globally – a tiny slice of the US$153tn global assets under management pie. Investment professionals therefore have an opportunity to capture alpha in the more ‘inefficient’ private capital markets to enhance value for clients and find better returns amid a market flooded with low-cost equities products.
Private capital classes including infrastructure are set to offer significant opportunities to global investors, with investment required to finance the energy transition and decarbonisation, build vital digital infrastructure such as data centres and fibre broadband networks, as well as roads, hospitals, bridges, and airports in developed and emerging economies.
The UK government has announced plans to leverage £100bn of private investment by 2030 to finance its energy transition programme, while Africa faces a US$100bn annual infrastructure funding deficit, according to the African Development Bank, underscoring the global opportunities.
Africa presents infrastructure opportunities
Emerging growth markets, including Africa, present significant private capital investment opportunities, with infrastructure funds set to play a key role.
Brian Yalla, a Kenya-based capital markets manager at development agency FSD Africa, says private capital currently represents a small part of the overall investment market, and that climate finance, SME financing, and infrastructure, are three key areas set to experience growth in the years to come.
Africa has a young, growing population set to fuel demand for infrastructure Referring to the US$100bn funding deficit in Africa, Brian says that “the main impediment has been the lack of appropriate structures to enable large-scale investment in infrastructure”. But “innovative structures including but not limited to public–private partnerships, guarantee facilities and blended structures are emerging as some of the approaches that are providing a solution to this and driving more private capital into infrastructure projects,” he adds.
According to Brian, demographic trends make Africa an attractive investment market, with a young, growing population set to fuel demand for infrastructure. “Investors are becoming more comfortable with this, and the sovereigns realise they need external investment to build bridges, roads, airports and apartment blocks.”
Brian expects the private market investor base, currently dominated by development finance institutions and institutional investors such as pension funds, to widen in the coming decade as institutional interest grows, “and more stakeholders begin to appreciate the asset class”.
Governments across the region are taking steps to open up their markets to overseas investment, says Brian, and “regulators in Africa, most of whom also have market development mandates in Africa, are considering regulatory approaches that can open up such markets”.
Pros and cons of private capital
Amid a proliferation of low-cost equities products and ‘beta creep’, investment managers need to be “more ‘creative’ in expanding their investment opportunity set”, according to CAIA’s chief information officer Mark Anson, quoted in the Portfolio for the future report.
They also need to meet their obligations and conduct their strategy with a responsible level of risk. Andrea Auerbach, Cambridge Associates' global head of private investments and one of the co-authors of the report, writes that private capital strategies are “well worth the challenge of illiquidity, immense return dispersion and the need for patience”.
Auerbach argues that alternatives can liberate investors to take advantage of market dislocations, information asymmetry and countercyclical opportunities, as they are “detached from the short-term machinations of the public markets”.
The only downside of private capital, according to Auerbach, is managing illiquidity and the potentially long timeframes involved while waiting for managers to sell assets.
Some of the challenges facing investment managers considering private capital allocations include extensive due diligence on managers, including their environmental, social, and governance (ESG) credentials, and consideration of illiquidity risk, high fees, income needs and risk tolerance, says the report.
Professional investors must also adopt a fiduciary mindset as they engage in private markets, navigating conflicts of interest, “incentive dislocations between limited partners and general partners (GPs) and unnecessary financial engineering”, writes co-author Roger Urwin, global head of content at the Thinking Ahead Institute.
The report also cites the difficulties of capturing alpha in the private markets, with a wide variation in performance across alternative asset classes.
Co-author Ashby Monk PhD, executive director at the Stanford Research Initiative on Long Term Investing, argues that firm culture, governance and technology are more predictive of sustained performance than previously thought, and that investors will also need to take these factors into account.
Bigger part of the picture
William Kelly, president and CEO of CAIA, held a virtual discussion with CISI in 2022 outlining the key findings in his group’s private capital report, and the myriad opportunities available across alternative investment classes globally.
Speaking subsequently to The Review, Bill says that the more inefficient private markets “have to be a bigger part of the picture” as investors seek diversification and higher returns away from efficient traditional markets “that are not growing”.
He says the shift from defined benefit pension schemes to defined contribution schemes will make more investment managers look towards alternative asset classes as they seek greater value creation. “Companies are staying private much longer,” he says. “They used to have to go public to raise capital. Now there's so much capital moving around in the private markets, by the time companies are going public today, in many cases it's a dozen or more years after their formation, and a lot of that value has already been created. We've got to find ways, as individuals, and as an industry, to allow us to participate much earlier in the value creation chain.”
However, he acknowledges the difficulty in finding value in the private markets. “If I have to invest 15% in private equity, what does that mean? What about the general partner? What about geography? What’s my performance measurement? There’s a lot of opportunity out there but getting there isn’t a clear line.”
Investment professionals will need to manage client expectations due to the differences in measuring performance and returns
Reviewing performance data on private funds like private equity GPs and infrastructure fund managers can be a challenging task for smaller investors with fewer resources, he says, noting that alternative investment funds with median return profiles are “very unattractive” compared to an equities index fund once you have taken fees into account. This makes it imperative to perform due diligence and seek access to the top tier of managers. But smaller investors have historically struggled to access top-tier managers, describing the private equity space as “closed”, says Bill.
“The performance dispersion from the median [private equity] manager to the top quartile is separated by thousands of basis points,” Bill explains. “So, you might have a median return of 10%, but the top quartile is 25%.”
While most small wealth and investment managers and financial planners don’t have global investment firms at their disposal to build alternative investment portfolios for them, new platforms have emerged to provide easier access to private capital markets.
Moonfare, for example, provides smaller investors access to top-tier private equity funds as well as infrastructure funds further down the risk–return spectrum. The company’s digital platform pools commitments into feeder funds that invest in private equity vehicles. Moonfare allows investors to allocate capital to individual funds or build a portfolio of different funds.
Another US-based platform, iCapital, also offers qualified investors access to alternative investment fund managers, such as PE firms, further underscoring the growing options for smaller-scale investors in the alternative asset space.
While private capital markets are becoming easier to access, investment professionals allocating capital to alternative assets will need to manage communication and client expectations due to the differences in measuring performance and returns.
Bill says investor clients are typically used to cash on cash return and would need to get comfortable with alternative investment measurements such as internal rate of return (IRR). As IRR is more of a measurement of money “in the ground”, rather than money set aside, the differences need to be communicated carefully with clients, he says.
“Eventually, private debt matures, private equity portfolio companies get sold, and valuation is realised, but to think about a mark, quarter-to-quarter, month-to-month and try to equate that with the public equity markets is very hard to do,” Bill adds.
With increasing access and greater data visibility, private capital allocations have a significant role to play for wealth managers and investment managers in the years to come.
“That’s where value creation and capital creation is happening,” he concludes. “If investors and clients are getting access to that, that’s a very good thing.”